Why Government-Enforced Financial Security Destabilizes Banks

Thanks to the recent swathe of banking regulation, investors can expect the money market funds associated with their brokerage accounts to become less and less temping as cash management products, with disastrous consequences for the system as a result. At the moment, these funds serve as a place to park uninvested funds while looking for an appropriate opportunity or as a longer-term location to store cash as a risk hedge in a larger portfolio plan. Most brokerage clients might not even consider it an investment; thanks to automatic sweeps of cash in accounts, clients can earn interest on their uninvested balances.

 

As anybody with such an account can attest, the returns have tanked in the past decade, and thanks to investors’ friends at the SEC, they stand only to drop farther. As reported by the Wall Street Journal, “under the new rules, established by the Securities and Exchange Commission in January, money funds must hold more liquid assets and limit their investments to only the highest-quality securities. In addition, they must reduce the average maturity of the securities they hold.” More specifically, a certain portion of the fund portfolio must be convertible to cash in one business day (10%), and another portion must either mature in less than 60 days or be convertible to cash in a week or less (30%).

 

Dry as this may sound, what it means is that the SEC is now telling investors two things: investment-grade cash must be very liquid to be safe, and government Treasuries are one of the only safe and liquid investments. But the industry response remains abundantly clear: when ultra-low risk funds with expected returns in the range of 0.18% drop below $1 per share, it shows distaste for the product. Likewise, Vanguard has stopped offering many of its funds for reasons of profitability. Many of the remaining funds presently operate at a loss as managers have lost the flexibility to push for higher yields.

 

So, every savvy investor, if offered a higher safe return elsewhere, will pull his cash from these funds, and the industry has obliged. For the past decade, high-interest savings accounts have grown in popularity, and at present, most of them offer returns ten times greater than the money market funds, and the savings accounts come with FDIC insurance. The returns are still a pittance, but for high-balance and risk-averse clients, the switch will occur.

 

The snafu for the industry comes from the nature of the firms to which and from which capital will flow. Liquid capital will leave brokerages and go to discount banks often owned by credit card companies. The problem enters in that large banks with large capitalization requirements like Citibank, Wells Fargo, and Chase will lose reserves to companies that do not have problems meeting regulatory requirements. In short, the SEC regulations not only decrease an investor’s potential cash returns, they likewise push capital from the institutions that need it the most to remain globally competitive.

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